Am I the only one having flashbacks to 2008? The current banking crisis is strikingly reminiscent of what we went through 15 years ago and stems from the same basic root—a failure on the part of banks to adequately hedge the risks associated with loans and mortgages they had issued.
As the Fed has been raising interest rates to combat inflation, the fair market value of fixed income securities has plummeted. The policy rate climbed from zero to 5.25% in a relatively short period, which has added considerably to the banking sector’s problems.
This may have started out as a regional banking crisis, but it is really a systemic problem. It is not just regional banks that are stuck owning long-dated fixed income securities issued at extremely low interest rates. Bank of America
BAC
for example, one of our nation’s largest lenders, has big exposure to unrealized losses on its books as well. Ominously, so does the largest owner of these securities, the U.S. Federal Reserve.
Today, most healthy banks have an equity capital buffer of 10-13%, but many have less. The rest of their balance sheet is typically financed with deposit liabilities and/or debt. Usually, deposit liabilities are extremely short-term in nature so any rapid reduction in depositor confidence often leads to liquidity issues. That’s why banks can’t function without FDIC insurance for depositors.
Recently, many banks started carrying significant unrealized losses in their fixed income assets on their balance sheets because interest rates had climbed so much. If all banks marked these assets to market, as any good accountant would demand, their depositors would panic since equity capital cushions would crater. In turn, bank stock prices would plummet, and failures would multiply as confidence vanished. It probably doesn’t help that a bank’s depositors can see the share price minute by minute. They may view that as a proxy for the health of an institution and, if it drops too far too fast, they may quickly move their cash elsewhere.
First Republic failed because it had lost the confidence of its customers. It replaced Silicon Valley Bank as the second largest bank failure in US history. We have now witnessed three of the four largest bank failures in US history in just a matter of weeks. Similarly, the Credit Suisse failure overseas was massive.
In his press conference on May 3 announcing the latest interest rate hike, Fed Chair Powell began by saying, “The U.S banking system is sound and resilient…We are committed to learning the right lessons from this episode and will work to prevent events like these from happening again.” However, it doesn’t look like we learned the right lessons the last time around and I’m not sure we will this time either. Historically it’s usually not just one or two banks that fail during a market cycle. It’s usually a number of banks, sometimes hundreds, because they all have similar risks, and they’re all leveraged.
The purchase of First Republic’s assets by JP Morgan is another throwback to 2008 when JP Morgan acquired the assets of both Bear Stearns and Washington Mutual. By making the move to take over First Republic, chairman Jamie Dimon, like Powell in his statement to the press, was likely hoping to calm depositors’ fears and signal that the crisis was over.
Although as a matter of policy the public is probably best served by a mix of banks of all sizes, in times of crisis the FDIC allows big banks to get bigger by swallowing failing rivals and that’s been an effective solution during times of crisis. The goal is to show stability and instill systemic confidence so that depositors leave their cash in banks and the banks can make new loans to support the economy.
Whether or not such a deal is good for the acquiring bank isn’t always clear. The Bear Stearns and WaMu deals ended up costing JP Morgan considerably more than originally anticipated due to legal settlements to resolve the defunct banks’ obligations. With First Republic, JP Morgan got billions of dollars in deposits and high-net worth relationships, but many of the new branches it acquired were in markets that JP Morgan had already saturated. One attraction was the underlying loan book which cost JP Morgan ~80 cents/$. It is a big book, but a discount of 20 cents/$ may not be enough and only time will tell how this investment performs.
So far, no depositors have lost money from these bank failures, but the same isn’t true for the investors who owned their bonds, stocks, and/or preferred shares. It is shocking to see the amounts of losses that some of these shareholders are taking, hundreds of millions of dollars, or even billions. Many of the biggest holders of these banks’ shares were ETF Funds that bought them simply because they were part of an index. Those who held First Republic shares watched the value plunge from over $147 in February to just 33 cents by May 4. On the other hand, anyone who could see the problem and short-sold regional bank stocks probably came out ahead.
As we noted at the start, in 2022 interest rates shot up dramatically and that drove widespread losses in fixed-income markets. Of particular concern is that the Fed is the largest holder of fixed income securities, ~$9 trillion worth, and that the two largest quasi-governmental agencies, Fannie Mae
FNMA
and Freddie Mac, are still in conservatorship. Although this has been widely reported, most prognosticators didn’t foresee how rapidly rising interest rates would impact regional banks. In addition to tighter monetary policy, the war in Ukraine, inflation, risk of recession, and the risk of a US government default are all causing investors to lose their appetite for risk taking.
However, the current investing opportunity set has become much more favorable for astute distressed securities investors. In this environment, you have to be nimbler and careful on the long side. Precious metals and some other inflation-protecting investments might make sense now. We’re also starting to see a lot more distressed debt and some of it is priced very attractively right now. There are lots of big bankruptcies—National Cinema, Diamond Sports, and Bed Bath & Beyond
BBBY
, to name just a few. Default activity was heavy in April with the volume of HY default/distressed exchanges increasing to a 33-month high. However, those figures only included high yield debt borrowers. They don’t include the four major bank failures from the last few weeks and nor do they include the giant Credit Suisse default. Adding those in would more than double the YTD total.
In this environment, investors would be well-advised to begin allocating a portion of their portfolio to distressed debt. Selective purchases of certain distressed debt issues should yield attractive risk-adjusted returns going forward. At the same time, short selling of companies headed into trouble should be a focus area since more and more companies are becoming distressed in this new macroeconomic environment. Last but not least, investors should always do their homework and pay attention to fundamentals.
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